DAO & VC: Improbable Partners Today, Fierce Rivals Tomorrow

On November 18, 2021, an original copy of the U.S. Constitution was put up for sale at Sotheby’s auction house. It looked like an ordinary auction, the likes of which the renowned auction house had held thousands of times before. However, this one turned out to be different as thousands of people mobilized over the internet to pool funds and make a bid. This crowdfunded initiative (named ConstitutionDAO) managed to raise $47 million in a week by bringing together more than 17,000 people who wanted to contribute. But the bid failed, with the item selling for $43.2 million (allegedly, had ConstitutionDAO beaten that bid, there wouldn’t be enough money left for the care, preservation, and custody of the document would). The failure raised questions about the fate of funds collected as there is no legal framework regulating the crowdfunding campaigns led by DAOs. It turns out that ConstitutionDAO had an “act-first-think-later” approach. Not much thought was put into what would happen after the auction—whether the bid was successful or not, the members of the ConstitutionDAO would vote on different proposals to figure out what to do.

The ConstitutionDAO case illustrates both what is exciting and scary about investment DAOs. On the one hand, the unparalleled agility and speed DAOs offer in mobilizing people, pooling funds, and investing in projects have great promise for startups. On the other hand, the lack of accountability or any form of legal recourse in case things don’t go well are significant hurdles that might prevent DAOs from becoming the mainstream instruments for investment. The p opular crowdfunding platform Kickstarter gives you the option of backing out of a commitment to support a project during the funding period (the funds get locked in only when the project goal is met). DAOs, on the other hand, don’t have any similar regulations in place at the moment. Regulating how DAOs work, establishing strict rules as to what should be done when a project doesn’t meet its goals (or how DAO members are to be compensated in case of fraud), or turning DAOs into limited liability companies can bring accountability to this niche segment. But this would probably come at the price of the spirit that makes DAOs special in the first place. A tightly-regulated DAO will not be the fun, impulsive, and agile organization people love being a part of. 

The ConstitutionDAO saga may have serious implications for Venture Capitalists (VC). VCs are indispensable to a lively startup ecosystem. They evaluate projects, spot talent, envision what may come of a particular product, and make investment decisions, some of which turn out to be real breakthroughs. However, the relationship between VCs and startups has never been egalitarian. The VCs have been in the driver’s seat while startups pitched their ideas to them and looked for funds, guidance, and a chance to make their dreams true.

The conventional fundraising process feature startup founders as mere mortals pleading their cases in front of the gods of Olympus, that is, the VC executives. This process gives VC executives more credit for spotting talent than both they deserve and the very talent in question could hope to receive. Some fund managers have even reached rock star status for investing in projects that later became hugely successful. People like Paul Graham of Y Combinator, Marc Andreessen of Andreessen Horowitz and Mark Maples of Floodgate have become celebrities, much lauded for the Midas’ touch they possess.

DAOs have the potential to change that, however. The democratization wave, which has hit everything from software to finance to content creation, is about to hit the VC firms as well. The recent crowdfunding initiatives organized under DAOs, with their agility and passion they instill in contributors, threaten to transform the whole investment landscape. Unlike VC companies that act upon financial projections, calculations, and a reputed sixth sense resulting from experience that investors use to judge the potential of a project, DAOs act like digital tribes at times, relying on a community’s belief in a supposedly righteous cause, or even pure hype in some cases. As crypto startup Multis found out, the decision-making process of DAOs can be astonishingly swift. They only need a few hours to decide whether to invest in a project and if they do, the startup gets its money within the day as opposed to 15 days when pitching to a VC.

Having noticed the appeal DAOs have for startups, VCs want a piece of the action, too. However, DAOs would like to see VCs support them on DAOs’ terms, whereby VCs would see them as equals. This desire may translate into a reversal of roles regarding who is pitching and who is deciding. The controversy surrounding SushiSwap in 2021 presaged this possible future. When a group of VC firms, including Lightspeed Venture Partners, Breyer Capital, and Polychain offered to buy governance tokens issued by SushiSwap at a discount, some members of SushiSwap objected. The disgruntled members questioned the value VCs would bring in and accused them of just chasing a quick buck. SushiSwap members still haven’t decided whether to take the VCs on their offer yet, but this new situation requires VC executives to pitch their proposals to the DAO community and engage in lobbying to earn the goodwill of other stakeholders. a16z committed to this change in strategy and took the plunge, recently investing in Friends with Benefits (FWB) DAO and becoming one of the first VC firms to navigate these waters.

DAOs draw interest from VC companies because they are slated to generate a healthy return on investment. However, in the sense that DAOs are investors themselves like the ConstitutionDAO case illustrated, they are rivals with VCs. DAOs and VCs represent two different eras in investment, and their respective philosophies couldn’t be any more different. While VC companies are top-heavy, hierarchical, and opaque in the way they operate, DAOs are made up of people who detest hierarchy and put so much value on total transparency that it may be detrimental to their cause (the owner of the winning bid in the ConstitutionDAO case definitely knew how much money the DAO had raised because it was no secret).

An advantage DAOs have over the VCs is how they simplify the bureaucratic procedures associated with an investment. Usually, whenever a VC invests in a startup, a great deal of paperwork regarding the investment, reporting, administration, and dividend payouts ensue. Companies sometimes need to hire expensive consultants who can help with these tasks. All of these costs are of the recurring type. With DAOs, smart contracts take care of them all, and the only cost involves the initial coding of the smart contract.

DAOs and VCs definitely have common scenarios they can cooperate in, where the former can bring in its agility and passion, and the latter, its networking ability and financial acumen. However, the really interesting part would be to see whether DAOs can dethrone VCs as primary investors in the startup ecosystem. Smart money says that they can. But for that to happen, they should capitalize on the lack of administrative hassle and put in place a legal framework, taking care of the legal accountability issues and instilling trust in potential contributors.